Do Something!
Why You Need a Plan Before Markets Decline
When markets experience a sharp decline, our natural instinct kicks in—we want to do something, anything, to stop the pain.
Often, that "something" means selling our positions to stop the bleeding.
But is this really the best course of action?
The Market Timing Trap
When you sell to avoid losses, you're making a market timing call. And now you're on the hook for another market timing call.
When to buy back in?
Do you think you can make two correct market timing calls in a row?
Let's do some simple math. Even if you're exceptionally skilled and have a 60% chance of getting each decision right (which is optimistic), your probability of successfully executing both decisions is only 36%.
Now compare that to the 79% probability of positive returns for a 1-year holding period.
And this assumes you're making completely rational, unemotional decisions.
More likely, investors wait to buy back in when things have "calmed down", which usually means the market is already trading higher.
They end up selling at low prices and buying back at higher ones. The opposite of successful investing.
Know Your Investment Identity
To thine own self be true
What kind of investor are you?
Are you a day trader, swing trader, or trend follower? For whom short-term trading might make sense? Do you have the systems in place to trade efficiently? Do you have the temperament for this style of investing?
Or does your strength lie in fundamental analysis and identifying undervalued or high-quality companies?
I know my strengths lie in identifying high-quality companies, and my temperament allows me to endure large price swings.
I often joke that I invest in quality companies because I'm "lazy". I want to find companies that can do the heavy lifting of compounding their intrinsic value over time. These are businesses that generate substantial cash flow and can reinvest that money into other high-return opportunities.
Swing trading and trend following sound like too much work.
Plan in Advance
Develop your plan before market turmoil hits—this ensures you'll know exactly what to do rather than making panic-driven decisions.
Shopping List
Market declines offer opportunities to buy high-quality companies that were previously too expensive. Of course, this assumes the business fundamentals remain intact.
Maintain a watchlist of companies you'd like to own, along with the specific price you're willing to pay to achieve your target returns.
When these companies' shares drop during broad market declines, you'll be ready to act. Since you've already decided, before any market turbulence, that you want to own these businesses. All that's left is to stick to your plan.
Portfolio Rules
Have pre-determined minimum and maximum position size rules.
The primary purpose is to build systems that reduce our biases in decision-making. These rules force us to trim our winners when they become too large in our portfolios, freeing up capital to buy other names when they get cheap or to add to underweight positions.
This differs from the disposition effect of selling winners to invest more in losers. We're only slightly trimming winners to maintain our maximum position size rule. We still maintain the position, and since it's hitting this threshold, it remains one of our largest holdings. We simply don't want our portfolio to become concentrated in a single stock. This trimming approach is what the Connoisseurs from The Art of Execution do.
The minimum position size rules compel us to buy stocks we still like when they fall below certain thresholds.
During broad market declines, it's easy to freeze up and avoid adding to underweight positions. It's the fear of a further market decline creeping into our decision-making process.
That's precisely why we need this rule. It prevents us from letting emotions drive our decisions.
We want to buy high-quality companies when they're cheap. When the opportunity arrives, we must act. If the market declines further, so be it. While we can't control or predict short-term market moves, we can focus on which companies to buy and what prices to pay for them.
Price Discipline
None of this pre-planning matters unless we maintain our price discipline.
I've stated here before that it's okay to pay up for quality. And that remains true—up to a point.
Howard Marks says everything is a triple-A investment at the right price. But the opposite is also true, anything is a terrible investment if you pay too high a price.
Having clear valuation guidelines helps prevent us from overpaying and making poor investments, and it provides a framework for buying during market declines.
The Bottom Line
Market declines are inevitable.
Rather than trying to avoid them through market timing, focus on building a portfolio of high-quality companies that can weather the storm and potentially emerge stronger.
Complement this strategy with sound portfolio management rules and systems that reduce the need to make crucial decisions when emotions run high. Your success depends more on having the right system in place than on making split-second decisions during market turmoil.